Is It Time to Reassess Your Risk Tolerance?

December 2, 2024 Rob Williams
How much risk can you really handle? The answer may surprise you.

Market shocks are an inevitable part of investing—but that doesn't make them any easier to stomach. Whether you're just starting out or you've been saving for decades, watching the value of your hard-earned gains drop overnight can cause you to question the entire enterprise.

When the market is going up, it's easy for investors to think they're more comfortable with risk than they actually are. But whenever the S&P 500® Index drops into bear-market territory, people may be forced to confront their true risk tolerance—as well as their capacity, or ability, to take risk. 

So, how do you go about reassessing your tolerance for risk, come what may? Ask yourself these three questions.

1. How much can I stand to lose emotionally?

Investing is an act of faith—to say nothing of willpower. The assets that offer the highest potential reward are often the riskiest, but if you can steel yourself against occasional surges in volatility, you're more likely to reach your long-term goals.

The question is, how much risk can you really handle? To help answer that question, consider the downsides and upsides of five hypothetical portfolios:

More pain, more potential gain

Consider five hypothetical portfolios—from conservative (smallest allocation to stocks) to aggressive (largest allocation to stocks)—with an initial investment of $10,000.

A conservative portfolio has 20% allocated to stock, a moderately conservative portfolio has 40%, a moderate portfolio has 60%, a moderately aggressive portfolio has 80%, and an aggressive portfolio has 95%.

When looking at average annual returns, the greater the allocation to stocks, the greater the potential upside . . . but also the greater potential downside.

Best-year and worst-year portfolio returns for a conservative portfolio were 22.8% and –9.5%, 26.9% and –13.3% for moderately conservative, 30.8% and –20.9% for moderate, 33.9% and –29.5% for moderately aggressive, and 38.3% and –36% for aggressive.

After time, the portfolios with greater stock allocations had significantly larger values than those with smaller allocations.

The value of a conservative portfolio with an average annual return of 7.1% was $427,537, moderately conservative (8.4%) was $87,662, moderate (9.3%) was $1.3M, moderately aggressive (9.9%) was $1.75M, and aggressive (10.3%) was $2.14M.

Source: Schwab Center for Financial Research with data provided by Morningstar, Inc. Data from 01/01/1970 to 09/30/2024.

The hypothetical conservative allocation is composed of 15% large-cap stocks, 5% international stocks, 50% bonds, and 30% cash investments. The hypothetical moderately conservative allocation is 25% large-cap stocks, 5% small-cap stocks, 10% international stocks, 50% bonds, and 10% cash investments. The hypothetical moderate allocation is 35% large-cap stocks, 10% small-cap stocks, 15% international stocks, 35% bonds, and 5% cash investments. The hypothetical moderately aggressive allocation is 45% large-cap stocks, 15% small-cap stocks, 20% international stocks, 15% bonds, and 5% cash investments. The hypothetical aggressive allocation is 50% large-cap stocks, 20% small-cap stocks, 25% international stocks, and 5% cash investments. The return figures represented are the compound average, minimum, and maximum annual total returns of hypothetical asset allocations. The hypothetical asset allocations are weighted averages of the performance of the indices used to represent each asset class and are rebalanced annually. Total returns include reinvestment of dividends, interest, and other cash flows. The indices representing each asset class are S&P 500® Index (large-cap stocks), Russell 2000® Index (small-cap stocks), MSCI EAFE® Index-Net of Taxes (international stocks), Bloomberg US Aggregate Bond Index (bonds), and FTSE U.S. 3-month Treasury Bill Index (cash investments). CRSP 6-8 Index was used for small-cap stocks prior to 1979, Ibbotson Intermediate-Term Government Bond Index was used for bonds prior to 1976, and Ibbotson U.S. 30-day Treasury Bill Index was used for cash investments prior to 1978. The example is hypothetical and provided for illustrative purposes only. It is not intended to represent a specific investment product. Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly. For more information on indexes, please see schwab.com/indexdefinitions. Past performance is no guarantee of future results. Investing involves risk, including loss of principal. Average, Best, Worst values include YTD 09/30/2024.

Although portfolios with larger allocations to stocks have historically delivered higher returns over time, they have also been more volatile—which may not work for everyone. If you need the money in the next few years, for example, you should choose a more stable investment mix. The same is true if you simply can't bear to see your portfolio plummet in value.

It's perfectly reasonable to accept lower returns in exchange for more stability, but depending on your objective, that may mean you may have to save more—or ratchet back your expectations—to compensate.

Indeed, reducing your exposure to stocks and other relatively higher-risk, potentially higher-reward assets during your peak earning years comes could cause you to fall short of your goal. Market turbulence feels risky because it's something you have to face again and again. But if you have long-term goals, the more pernicious risk comes from undercutting your long-term returns because there's often no coming back from that.

2. How much can I stand to lose financially?

While many people think about risk in terms of their ability to endure losses emotionally, there's another component to risk that's equally important: your capacity to recover financially. 

Time is a big factor here. When you've got a decade or more until you need to tap your savings, short-term volatility isn't a big risk. But if you'll need the money in, say, five or fewer years, a market downturn can be devastating.

Be that as it may, your financial capacity for risk may not square with your emotional tolerance for it. An investor in their 40s, for example, probably has 20 or more years until retirement, which should allow them to invest aggressively. But some people simply can't tolerate the ups and downs of holding that much stock, regardless of their age or time frame.

Conversely, even aggressive investors can be waylaid by adverse life events like losing a job. If you need to tap your long-term savings to make ends meet, your capacity for risk can shrink overnight. In such situations, downshifting your exposure to help preserve capital could absolutely be the right approach.

Of course, in a perfect world your financial plan would have a built-in cushion for such emergencies. With an emergency fund in place, you're less likely to need to tap your long-term investments to cover short-term expenses. 

Nonretirees should maintain at least three (and ideally six) months' worth of essential expenses in a highly liquid account. However, if you're nearing or in retirement, it may make sense to increase your emergency fund savings to support at least a year's worth of spending, and then in a separate account or as part of your portfolio, dedicate another two to four years' worth of anticipated expenses to historically more stable investments such as high-quality bonds or bond funds. Keeping that much cash and short-term investments can help you avoid having to sell assets during a downturn.

3. How well do I know myself?

It's difficult for investors to predict in advance how they'll respond to a given set of market conditions, such as a down market, until it occurs. Consider asking someone close to you to rate your risk tolerance. You might think you're comfortable with risk, but your spouse or a close friend may be able to identify patterns of behavior—such as your tendency to play it safe in other areas of your life—that you're unable to recognize in yourself.

Financial advisors are ideally suited to this role because their experience with a broad range of clients can lend some perspective on where you fall along the spectrum of risk tolerance. As they get to know you, they can remind you how you felt, or reacted, in prior down markets and may also be able to help you identify whether you're acting with your head—or your heart. 

An advisor can help you "ignore the noise," like short-term market fluctuations and sensational headlines, to curtail the emotional responses that might otherwise get the best of you. In fact, one of the most significant services an advisor can provide is helping you stay the course—based on a true and impartial assessment of your risk tolerance as well as your capacity to take risk—should you ever need money from your portfolio during a market downturn.

Don't let your feelings get you down

Investors who frequently acted on their emotions and moved their money in and out of funds during market volatility had smaller returns than the average fund return over 5- and 10-year periods.

The average annualized returns for investors who moved in and out of funds was 95 basis points lower per year than the average fund return after five years and 106 basis points lower after 10 years.

Source: Schwab Center for Financial Research with data provided by Morningstar, Inc. as of 12/31/2023.

Fund return is the weighted average time-weighted return of all active funds in the Morningstar domestic equity, specialty, and international stock categories. Each fund is represented by its oldest share class. Investor return for each fund is calculated by Morningstar and reflects the average return on all dollars invested based on estimated monthly net fund flows. The average investor return and average fund return are averages weighted by the size of each fund. Only funds with both the fund return and the investor return are included in the analysis. Past performance is no guarantee of future results.

You can't wish your emotions away, but try to keep them in check. An advisor can guide you through reviewing your portfolio against your broader financial plan during market swings—as well as anytime your situation changes substantially.

Bottom line

While it's wise to take into account your age and time frame when managing your portfolio, your risk tolerance ultimately comes down to figuring out how much risk you can really afford financially, and handle emotionally. Once you know that, you can put together a plan that balances your long-term need for growth with your near-term need to manage your impulses.